Valuation discount persists

Rating maintained

• We maintain our 2 (Outperform) rating and six-month target price of S$0.70, based on parity to our RNG valuation (a finitelife Gordon Growth model. We believe Starhill Global’s discount to the other retail-property S-REITs is unjustified. It is currently trading at sustainable DPU yields of more than 7% based on our FY10-12 forecasts.

Major risk: overcoming its perception problem

• We believe the sponsor, Malaysia’s YTL group (Not rated), has a perception problem. The injection of two Malaysian assets, Starhill Gallery and Lot 10, from the sponsor’s Malaysian REIT at a net-property income yield of 6.8% with a tax-efficient assetbacked securitisation structure, has received, at best, a lukewarm reception from the market so far, in our view. We believe the negative perception does not justify Starhill Global’s valuation discount, although it might take some time for investors to become more comfortable with the sponsor. We believe more clarity on how the assets perform after the acquisition and the leadership of new CEO, Ho Sing, appointed by the sponsor, could go a long way to dispelling the negative perceptions.

Orchard Road supply concern is receding

• We believe the stronger-than-expected absorption of new retail space last year and the modest level of forthcoming supply for the primary shopping area are positive for Starhill Global. As long as Wisma Atria and Ngee Ann City remain relevant (another opportunity for management to prove itself), we expect them to attract their fair share of quality tenants.

Compelling investment case; initiate with BUY rating

High quality assets. Starhill Global REIT (Starhill) owns 13 properties across five countries with retail and office components. Starhill derives some 60% of its gross revenue from Singapore, where it holds stakes in Wisma Atria and Ngee Ann City, landmark assets on Orchard Road, Singapore’s premier shopping street. Other assets including the newly acquired Malaysia assets are also in high traffic, central locations, with mid-high end or luxury positioning.

Strong sponsor. Sponsor YTL Corporation Berhad (YTL), one of the largest listed companies on the Bursa Malaysia, holds a 28.8% stake in Starhill. YTL has clearly outlined its vision for Starhill as its main platform for ownership of prime retail and commercial properties in the Asia-Pacific region. The benefit is not just in terms of indirect and/or direct financial support – YTL has strong relationships with major global retailers such as Moet Hennessy Louis Vuitton (LVMH) and the Swatch Group.

Stable income profile with growth potential. Starhill enjoys a number of long-tenure leases and master leases that provide long-term income stability to the REIT along with potential for rental upside. Approximately 42% of Starhill’s revenue is derived from such leases (including the Malaysia assets). While we still see weakness in the local office market (estimated 13% of gross revenue), we believe retail sales will be on an uptrend in most of Starhill’s operating markets as those countries emerge from recession and begin to experience economic growth. We also see scope to grow income through asset enhancement initiatives and acquisitions.

Compelling investment case.Starhill is trading at a 34% discount to its book value (as of 31 Mar 2010). This compares favorably to Singapore-only retail and diversified retail/office REITs and overseas-only retail REITs which are trading at an average 1.0x and 0.8x price-to-book respectively. We believe the significant discount is unjustified when considering Starhill’s high-quality assets, healthy balance sheet and its strong sponsor. We value Starhill using our DDM-based valuation model, assuming a discount rate of 6.7% and a conservative terminal growth rate of 0.5%. This yields a fair value estimate of S$0.65, which is fairly reasonable, in our view, at only 0.79x price-to-book. This also translates to an estimated upside of 19% to the current price and an estimated total return of 26%. We initiate coverage of Starhill with a BUY rating. Key risks to our view include macro-economic headwinds, increasing competition in the retail space, foreign exchange risk and changing regulatory and taxation regimes.

A landmark transaction

• Asset portfolio to grow to S$2.6bn post acquisition of 2 Malaysian malls

• Partially funded through new issuance of convertible preference units (“CPUs”)

• Accretion to earnings estimated at 6-13% in FY10-11F

• Maintain BUY, TP revised to S$0.73.

Adding Malaysia exposure in its portfolio. Starhill Global REIT (SGREIT) has signed an agreement to purchase Lot 10 and Starhill Gallery (located in central Kuala Lumpur, Malaysia) from Bursa-listed Starhill REIT at a cost of RM 1.03 b (S$450.1m). Upon completion of the transaction, SGREIT’s portfolio of assets will increase by 20% to S$2.6bn.

Issuing new convertible units. The transaction will be funded through an asset-backed securitisation structure, involving cash (31% of purchase price), debt (32%) and the issuance of new convertible preference units (“CPUs”) (39%). The CPUs, amounting to RM405 m (est. S$177m) will be paid an annual coupon of 5.65%, and convertible into new SGREIT units at a 30% premium to the last vwap upon listing of the CPUs. There is a moratorium of 3 years before the conversion, which will turn mandatory after 7 years.

6-13% accretion to FY10-11F distributions. Upon completion, we estimate distribution income accretion of c6-13% in FY10-11F. We have also accounted for the conversion of all of the CPUs in year 3 into new SGREIT units.

BUY, TP adjusted S$0.73. Maintain our BUY call, with adjusted target price of S$0.73 assuming the full conversion of the CPUs from FY13 after moratorium period. Further price catalyst in our view may come from: (i) stronger than expected 1Q10 results, and (ii) clarity of its refinancing plans for majority of its loans due in Sept 2010.

Addition by subtraction

2 rating maintained – still trades at unjustified discount, in our view

• We maintain our 2 (Outperform) rating for Starhill Global because investor concerns about the sponsor and the pending acquisition of retail assets in Malaysia have created one of the rare value opportunities in the S-REIT market for this year, in our opinion. Starhill Global trades at an unjustified (in our opinion) 32% discount to its December 2009 NAV of S$0.82.

Attractive to us even without the proposed acquisitions

• As a measure of prudence, we have disgorged the estimated DPU contribution from the proposed acquisition of the sponsor's retail assets in Malaysia, Starhill Gallery and Lot 10, for RM1,030m, after an absence of concrete news on the deal since its announcement on 18 November 2009. Even after revising down our FY10-12 DPU forecasts by 11.7-14.6%, Starhill Global's DPU yield of 7.1-7.6% is well above those of the SREIT sector and its peers in the retail-property segment. If Starhill Global fails to acquire the assets, for whatever reason, we would not necessarily view it as a bad outcome.

A more rigorous target price of S$0.65

• Our six-month target price of S$0.65 is based on parity to our RNG valuation (a finite-life Gordon Growth model), in which we have discounted the expected income stream from its Singapore properties only at an effective cap rate of 5.89%. We have valued the overseas properties at their December 2009 net asset values, and have assumed that any acquisitions in 2010 would add no value to the overall portfolio.